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The information content of performance track records.
frequently overlooked but interesting characteristic of the returns of commodity trading advisors (CTAs) is depicted in Exhibit 1. The graph shows the average monthly return of an equally weighted portfolio of six large CTA funds that have long histories (going back to the early 1980s) during five market environments proxying different states of the global equity markets.
State 1 on the horizontal axis consists of the worst months of the Morgan Stanley World Equity Index from April 1983 through March 1997. In this state, the average returns for equities (-9.4%) and the CTA portfolio (4.1%) are graphed in the two bars. State 2 on the horizontal axis consists of the next worst months in the world equity markets, and so on. State 5 represents the best months for world equities, when they gained an average of 10.0% while the CTA portfolio returned an average of 4.5%.
The U-shaped pattern is consistent with an option-like payout. The CTA portfolio behaves, on average, like a "straddle" conditional on the different states of the global equity markets; it pays out the largest amounts during the extreme up and down months. It is easily demonstrated that this U-shaped pattern of the CTA portfolio returns holds also for individual stock markets (such as the S&P 500, Nikkei 225, FTSE 100, DAX 100, and CAC 40) as well as the world government bond markets. In fact, the positive payout during down markets is not due to a small number of observations, as shown by the persistent increase in the cumulative return of the CTA portfolio during down months in the global equity markets in Exhibit 2.
The option-like patterns of CTA returns are also observed in Fung and Hsieh [1997], corresponding to the returns of two "technical" trading strategies typically employed by CTAs and hedge funds.
Such a return characteristic is clearly desirable for diversifying a global portfolio with a significant equity content. Are these option-like return patterns likely to persist? Or is the pattern just another form of survivorship bias? If dissolved CTA funds do not exhibit a similar return pattern, the option-like payout features may not persist, because they may be specific to only a small number of surviving CTA funds....